The Art Of Algorithmic War
The Art of Algorithmic WarIf you know your enemies and know yourself, you can win a hundred battleswithout incurring jeopardy.Sun Tzu
In this market age of dark pools, contorted orders and ‘self’-learning machines, the battle notonly for alpha but also for simple survival looks more like war than ever before. What can brainscience teach Wall Street about both types of knowledge? Do we really know our enemy andhave we even considered self-knowledge as potent?The two interrelate.Emanuel Derman notes in Models.Behaving.Badly. (2012) that “the movements of stock pricesare more like the movements of humans than molecules.” Realizing that markets are humanconstructions should have made this observation obvious but as he discusses, modeling marketinteraction has resulted in artificial and inaccurate explanations of price action. We of coursehave the observations of Behavioral Finance that catalogue average or typical behaviors, but isdescribing such phenomenon enough? Even practitioners of Behavioral Finance admit their lackof a coherent theory to explain their data and this fact alone further exacerbates the need formore accurate theories.In particular, the spectrum of 21st century brain science offers a new theory of thinking itself. Itdiffers dramatically from the classic beliefs about reason, logic, feelings and markets. AntonioDamasio, Director of the Brain and Creativity Institute at the University of Southern Californiafirst outlined the change in his 1995 book Descartes’ Error: Emotion, Reason and the HumanBrain. In the almost two decades since Damasio’s groundbreaking work, brain science hascontinued to deliver more and more evidence that human perception, judgment and behavioremerge from the objects of Sun Tzu’s advice—the social (enemy) and the feeling or emotionalcontext (self).Thinking about thinking needs to move from overvaluing an individual’s intellectual icing tocapitalizing on the chemistry of the cake’s ingredients.This paper provides a brief overview of key subsets of the current research on perception andjudgment and outlines strategies and tactics based on neuroscientific insights for developingmore robust models, creating more effective algorithms and instituting more effective riskmanagement approaches. After setting the stage with insights from experimental finance andsocial neuroscience, the emphasis will turn to improving upon individual risk perception andjudgment. The ReThink Group, Inc. 20132
SOCIAL BRAINS: SOCIAL MARKETSWhile it should be obvious that markets are social constructions, their development from whatwe now know to be socially-mediated brains may not be as clear. For example, in examining thelink between brain development and the use of stone tools by humans, Grove and Coward (2008)note that in understanding the development of tools the important factor “is not the individualneuron, nor even necessarily the individual brain, but instead the socio-cognitive context inwhich brains develop and tools are manufactured and used.” In examining the development ofhuman cognition, Hasson, et.al. (2012) argue that “in many cases the neural processes in onebrain are coupled to the neural processes in another brain via the transmission of a signal throughthe environment.” Such coupling via signals—i.e. social interactions—lead “to complex jointbehaviors that could not have emerged in isolation.”Turning again to Derman (2012) and his erudite warning on mistaking the model for the thingbeing modeled, consider the possibility that the “thing” of markets can also be understood mostaccurately through the idea of a social mechanism. The efforts to interpret social mediasentiment via big data reduction equate to a “know your enemy” strategy. A brain scienceargument can be made however for analyzing the “social” even earlier in the quantitativeprocesses.Specifically, game theory offers backward induction or beginning at the desired outcome andreversing the moves as a perceptual aid. This means specifically thinking about whatdevelopments competitors may be working on. It also goes a step further to imagining how thosetypes of models and algos could impact price action. Justification to go beyond probabilistictools comes from Bruguier, Quartz and Bossaert’s (2010) experimental finance research. Theyshowed that human brains deliver more accurate price predictions when relying on whatneuroscientists call “Theory of Mind”—the innate human ability to predict other people’s futurebehavior.Imagine simultaneously playing chess and paintball. It is an apt comparison for the war ofmarkets. The game is or would be mental and physical, strategic and tactical all at the same time.Like the metaphor, our perception and judgment relative to the markets has mental and physicalas well as tactical and strategic components. As we will discus, the physical and emotional arenow known to be critical to our best thinking. Engaging in thought experiments that draw on The ReThink Group, Inc. 20133
real-life social competitions can be quite helpful in the idea-generation and in the “what if”testing phases of algo implementation.Peters (2012) research on the decision making of more numerate versus less numerateindividuals suggests that the highly numerate tend to overuse numbers in making decisions.While understandable as a way of reducing the anxiety involved in dealing in less precise factors,ignoring what brain science is delivering about the true importance of the social, feeling andemotional contexts leaves out potentially useful information.WHAT’S IN THE CAKE?One of the difficulties in deliberately improving risk decision making is the paradox of thefindings from research on the unconscious thought effect (UTE) or what is also known as thedeliberation without attention (DWA) phenomenon. Many of us have had the experience ofrealizing the solution to a decision or other type of problem “out of the blue” when our consciousattention was not focused on that problem. Dijksterhuis (2004) has shown improvements in theresults of decisions when the conclusion is drawn after a purposeful period of turning attentionelsewhere.While there are many studies that either confirm or disconfirm his findings, one criticallyrelevant to the risk-management element in the quant’s world comes from medical diagnostics(de Vries et.al. 2010). In comparing diagnoses in clinical psychiatric cases, their researchsuggests that unconscious processing significantly increased the correct number of classificationswhen compared to the process of consciously thinking about the information in the casedescription.A second example arises from what is now being recognized as body-based intellect. Calledembodied cognition, the field is demonstrating how physical events like tensing one’s muscles(Hung and Labroo, 2011) or standing up straight can increase perseverance on an unansweredproblem. Furthermore, in practicality we all know that exercise, for example, helps us think moreclearly. Development, testing and re-calibration processes can all benefit from individuals andteams having access to a gym during working hours.A third area of research that contradicts Wall Street’s thinking is how our brains deal with andactually rely on fear. First from a physiological point of view, the conventional wisdom in brain The ReThink Group, Inc. 20134
science and psychology holds that fear is mediated by the amygdalae—the almond shapedstructures on either side of our brains. Feinstein, et. al. (2013) recently found however that withcertain types of fear such as internal threats, the amygdala may be irrelevant. This changeseverything brain science thought it knew about how fear occurs. Further research byCunningham and Brosch (2012) suggests that instead these structures play a role in decipheringmeaning for any sensory input.Given the growing acceptance that thinking is the product of interactivity between the brain,body, neuroelectrochemicals and the social environment, the latter also speaks to the emergingcontroversy over the role of testosterone in building over-confidence amongst traders. Coatesand Herbert (2008) found that periods of success breed high testosterone which in turn appearscorrelated with excessive risk taking. Conversely, Stanton et. al. (2011) found that both high andlow testosterone individuals displayed less risk aversion.THE CONFIDENCE FACTORDamasio named his ground-breaking book, Descartes’ Error because Descartes, the 17th centuryphilosopher had declared “I think therefore I am.” Damasio’s research team was clearlydemonstrating the reality to be different - “I feel therefore I am” and so began the trilogy ofDescartes’ Error, The Feeling of What Happens and Looking for Spinoza. The essence of humanconsciousness, according to Damasio, is not cognition; it is feeling.Damasio has continued to be a leader in this new view of thinking giving presentations entitled“The Primacy of Feelings” at places like the annual meeting of The Society for Neuroeconomicsin 2011.Damasio and Gil Carvalho (2013) summarized the new view of human feelings:Feelings signify physiological needs like hunger, tissue issues like pain, threats in fearor anger and social meaning in compassion, gratitude or love. Feelings constitute acrucial component of life - from the simple to the complex. Their substrates can be foundat all levels of the human nervous system from individual neurons to the highest cerebralcortices.And Damasio is a far from alone. Widely regarded Cal-Tech Professor Colin Camerer and hiscolleagues stated in their meta-analysis of neuroeconomics published in the Journal of EconomicLiterature (2005) “it is not enough to know what should be done, one must also feel it.” The ReThink Group, Inc. 20135
In other words, in brain science circles, feelings and emotions have a completely different rolethan they do on Wall Street, where they are shunned or worse, ignored. First and foremost,researchers now agree that feelings imbue every single decision. Put another way, noneuroscientist would bother to advocate for emotionless decisions because they know such athing to be impossibleWHAT ARE FEELINGS FOR AND WHERE DO THEY COME FROMFeldman-Barrett and Bliss-Moreau penned “Affect as a Psychological Primitive” (2009) to saythat not only are feelings (called “affect” in academia) primary to all mental states but that ourwhole understanding of emotion, a subset, has been wrong. As proponents of what is called“Psychological Constructionism”, they reject the widely used categorization of the five basicemotions popularized by Ekman (1992) (and popularized in the TV show Lie to Me). And inother meta-analytic work, Feldman Barrett and Wager (2006) suggest that the only universallyvalid parsing of emotional experience is like/dislike or want/not want—what psychologists term“approach/avoidance.”In a meta-analytic review of the brain basis for emotion, Lindquist et. al. (2012) concluded:We found little evidence that discrete emotion categories can be consistently andspecifically localized to distinct brain regions. Instead, we found evidence that isconsistent with a psychological constructionist approach to the mind: A set of interactingbrain regions commonly involved in basic psychological operations of both an emotionaland non-emotional nature are active during emotion experience and perception .Agreeing with the findings of broad interactivity across brain regions, structures andneurochemicals, Anderson, Kinnison and Pessoa (2013) note that the ubiquitous reporting of thisor that brain structure or hormone as being singularly responsible for a given emotional orcognitive experience misleads the public as to what is really going on.FEELINGS AS DATAHow can this research be applied to improving the processes of building tools for trading andfinancial decision making? How can knowing yourself add to your ability to analyze thecharacteristics of a market? Two relatively easy ways come to mind when we think of theobserved aversion to ambiguity and the tendency to confirm existing beliefs. Called theambiguity aversion and confirmation bias respectively, these two Behavioral Finance The ReThink Group, Inc. 20136
observations can be recognized earlier in the process if one is naturally treating their feelings asdata. In other words, a practitioner can sense their desire to reduce the ambiguity or prove theirfirst idea correct.Next, our views on how feelings can work need to be changed. The aforementioned substantivemisunderstanding stems partially from failing to see the difference between a feeling itself andthe doing of or acting on the feeling. Underlying most of the non-scientific discussion on feelingsand emotions is the assumption that a feeling or an emotion automatically becomes an action.Logically, this is simply untrue. We feel things that they we don’t act on all of the time. Wedon’t punch our boss or grab and kiss the stranger in line behind us.Why are we able to do that? In those social situations, expectations of proper behavior andpotential punishment lead us to treat the feeling as information. The fact that our boss is beingunfair or the person behind us is immensely attractive gets treated like data—which is how thebrain is using it—and analyzed. A particular action may or may not occur—depending on theinterpretation of the incoming data.One area in which even analytical types are comfortable with feelings is when talking aboutconfidence or conviction. Even IBM’s Watson relied on an algo-generated “feeling” ofconfidence. Wall Street analysts and traders describe their conviction or lack thereof in much ofwhat they do. Confidence is the feeling—or at least one of a broad spectrum of feelings—thatmust be present to make a decision of any type. If one doesn’t have some level of confidence thatone choice is better than an alternative, the person will loop endlessly through the plusses andminuses for either choice.This is consistent with the idea that in their pure form, feelings and emotions are meant to informus. Without realizing it, Wall Street adds emotional information to analytic reports.From the brain’s point of view it appears that when we acknowledge and identify feelings, ourpsyches appear to be satisfied that the protective warning has been heard and as a result we havemore choices of behaviors. The ReThink Group, Inc. 20137
THE FRACTAL PSYCHEThe trick, which admittedly is no small feat whatsoever, lies in distinguishing between thefeelings that provide valid assessments of the current situation versus those feelings that arebased on patterns in the past that create expectations of the future.The latter appear to be either literally fractal or so similar that the idea of fractal patterns withinthe psyche provides a spot-on metaphor. Pezard and Nandrino (2001) in fact noted over a decadeago that research results of applying Chaos Theory to psychology, of which fractals are a part,reveals the concepts to be more than simply metaphorical.Additional research into the possibility of fractal geometry applying to the brain and thinkingcomes from Dixon, Holden, Mirman, and Stephen (2012) who said:Changes in cognitive performance exhibit a fractal relationship between size and timescale. These fractal fluctuations reflect the flow of energy at all scales governingcognition. The cognitive system exhibits not just a single power-law relationship but actually exhibits many power-law relationships, whether over time or space. Thischange in fractal scaling, that is, multifractality, provides new insights into changes inenergy flow through the cognitive system.For an example of how in fact the brain may mediate a fractal-like fear, Visser, et. al. (2013)discovered that the way a person experiences particular phobias, say a fall from a horse and alingering fear of horses, could be predicted by how the brain was firing at the time of the initialevent. In other words, past neurological activity becomes the basis for future experience.Theoretically, this could be the substrate for repetitive perceptions and expectations that appearto be fractal.Regardless of whether perception proves to be verifiably fractal or simply better understoodthrough the adoption of the metaphor, separating this subjective experience of emotion from thelarger mental database of informational feelings offers a powerful mechanism for knowingoneself and in turn reducing mistakes.(IRONIC) TOOLS FOR AVOIDING BIASESHow does a “quant” or a team of quants take brain science and use it in the context of Sun Tzu’sdirectives—know your enemy and know yourself? Particularly how does one do the latter whenso much of perception appears to be below our conscious levels? The ReThink Group, Inc. 20138
From the time of Freud, both body and feelings have been known to offer indicators of whatmight be intellectually unavailable. In a summary article reviewing what brain science calls“embodied cognition”, Reimann et. al. (2012) seek to answer if “emotions function as the bridgebetween bodily perceptions and downstream cognitive processing such as judgment and choice ” and it appears that the answer is “Yes.”In the world of Wall Street, where the typical techniques are quantitative—statistical time series,for example—practitioners need first to believe that capturing and categorizing the seeminglymessy and disorganized data of feelings will bear fruit. This brings us back to Sun Tzu and thequestion of knowing oneself as well as to Derman and the sheer volume of text he used inaddressing the subject of emotion in Models.Behaving.Badly.To the forward-thinking practitioners who seek to move beyond misconceptions about feelingsand emotions, the next steps include creating language, categories, definitions and tools. Each isneeded to be able to capitalize on feelings when brainstorming about the unexpected – anecessary process in algos for proprietary trading if not in agency models and the question of thenext dark pool’s behavior.In the realm of language and definitions, feelings include a sense of something like intuition(which can be considered unconscious pattern recognition or experiential learning) andemotional indicators of threat in the form of fear or anger.Changing one’s own thinking processes to habitually include detection and analysis of knownrelevant feelings and emotions serves two purposes. First, the odds of a feeling beingunintentionally acted on go down. This is risk management. Second, this new learning begins toopen up a wider door both to utilize intuition—unconscious pattern recognition—and to gain anedge on those agents who are not employing this tool.QUESTIONS TO INCORPORATEA number of tools are available to benefit from the information that feelings and emotions canprovide. The following questions can and should become not only culturally acceptable but derigueur in any question requiring judgment. Two examples from the systematic trading world arewhat is the proper period for implied volatility is and what definitely qualifies as evidence that analgorithm is failing? The ReThink Group, Inc. 20139
Recognizing one’s emotional state at any given moment and what one’s pattern is over time willcreate self-knowledge. Likewise, implementing the following three feeling-analytic questions ona systematic basis at the group level will improve group problem solving and avert groupthink.The first can involve an eight-point scale ranging from panic to e–Optimistic–Confidence–ArroganceGood decisions typically emerge when feeling contexts converge between doubt and confidence.The second should be a four point breakdown of one specific type of fear and anxiety. It relies onregret theory originally outlined by Loomes and Sudgen (1982) and is meant to uncover thenormal fear of future regret (FOFR) that is an integral part of many decisions—particularly thosemade in the Knightian uncertainty of trading. Such a breakdown specifically c
The Art of Algorithmic War If you know your enemies and know yourself, you can
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